Foreign Investment in China

China Law Professor Donald Clarke sent me a great article this week from New York Magazine, entitled, How China Drove Out Mister Softee. Professor Clarke’s email with the link said the following:

Thought you might like this. Interestingly, it is NOT a story of “guy skirts rules, naively trusts Chinese partner, gets screwed.” It’s “guy does everything absolutely by the book, has reliable Chinese partner who does not screw him, and still gets screwed by changing political atmosphere.” For him to get competition eventually is quite normal, and the competition wasn’t using a trade name similar to his. But the rules were not evenly enforced.

This is the sort of story I both love and hate. I love this sort of story because it is interesting and important but I hate it because I constantly and aggressively stress to my clients the need to follow China’s laws to the letter and with that I ought to be able to tell them that by doing so they will have no problems. I also hate this sort of story because it reveals the cynical truth that the reality is really more the opposite: if you do not follow China’s laws you will have a problem. If you do follow Chinese laws the odds of your having a problem will go way down, but hey, it is no guarantee. Truth is that as a foreign company doing business in China you will be a target and this means you must follow the laws to avoid being an easy and legal target but even if you do follow the rules you are still a target.

Quick aside. Why the Jim Carey clip about “messing with the doo?” Two reasons. One, It’s just a great clip. And two, I love soft-serve ice cream and I have fond memories of eating Mr. Softee ice cream when visiting my grandmother in New Jersey. So I see China’s messing with Mister Softee as the equivalent of “messing with the doo.” But I digress.

So if you read the New York Magazine article, you will learn that Turner Sparks brought New York’s iconic Mister Softee trucks for the first time to China” back in 2007 and eventually built his ice cream empire to ten trucks and 25 employees in Suzhou. You will also learn the following:

Mr. Sparks did local TV and newspaper interviews and was a fixture at school and corporate events, where he and his team doled out waffle-cone soft-serve to thousands. During one corporate party at Bosch, an international electronics company, he sold $9,000 worth of $1 cones in just two hours.

Competition was scarce, because he essentially invented the Suzhou ice-cream-truck market. “All these trucks were just going nuts, doing really well. Huge lines all the time,” he told me. “Everyone knew Mister Softee.”

He planned an ambitious expansion, and lined up investors to back it: He wanted to quintuple his fleet to 50 trucks, add more storefronts, and move into new territory.

More importantly, you will learn how tough it can be to do business in China, because you will learn that instead of expanding his business in China, Mr. Sparks ended up leaving China “with just enough money to reinvent his life as a New York stand-up comic.” and that “what happened to Sparks is an illustration of how the landscape has shifted for foreign businesses in China since current premier Xi Jinping has taken over the country, and the climate has become considerably less hospitable for foreign business — small ones, in particular.”

The article talks about how things began to change for foreign companies in China starting in 1978 and how Sparks was able to build up his ice cream empire:

They created a local supply chain from scratch, finding vendors for cones, straws and soft-serve mix at a Shanghai food-and-drink expo. Using secret blueprints from Mister Softee, the truck was built in Nanjing by a company that makes telecommunications trucks, armored vehicles, and ambulances. Workers were hired from a job fair, with many long-distance drivers jumping on the opportunity to work locally and try something different. To give the soft-serve the same taste as back home, they shipped the milk in from the U.S.

Suzhou officials worked with Sparks to create a new kind of business permit for their ice-cream trucks, called a Qualified Mobile Vendor License. It let them operate the trucks, but only as “delivery vehicles” for two stores. The license also required they have a staffed office and were restricted to operate at certain spots around the city. The solicitousness of Suzhou officials wasn’t unique. All around China, local governments were inviting in foreign businesses, easing the cost of doing business with tax breaks, and giving them friendly government liaisons to help them navigate the labyrinthine bureaucracy.

Then you will learn how the ice cream empire fell apart, for reasons that will likely not be unfamiliar to most foreign companies that operate in China — taxes and thieving employees who then go out and illegally and even violently compete:

The first inclination Sparks got that things were changing was around 2012, when a local official called him into his office and accused Sparks of not paying enough in taxes.

“Immediately, I knew it was a shakedown,” he said. “This guy was an idiot. He was like, ‘There’s money, I need some.’”

Sparks declined the man’s offer and left, but says that meeting was his first experience with the corruption he’d often heard about in China. Soon after, two new drivers alerted Sparks to a longtime scam by his eight other drivers. They were quietly making extra soft-serve sales and pocketing the money for themselves. Because Mister Softee was a cash business, office workers would count drivers’ ice-cream cones at the start and end of their shifts to make sure they weren’t stealing. To circumvent that control, drivers bought their own cones. When Sparks started measuring the ice-cream mix instead, the drivers would buy extra cones and mix, too.

Eventually, he instituted random checks on drivers and fired several on the spot when they were caught with more mix in their trucks than they had at the start of the day. Soon after, his tires outside his apartment were slashed. Then a fired driver showed up at Mister Softee’s office and threatened to kill the workers there.

Things got more bizarre. In early 2013, just a few weeks after they were fired, Sparks’s former drivers resurfaced with their own unlicensed ice-cream trucks, with knockoff names including Baby Bear, Snow Princess, and Mr. Big. These drivers would park along Mister Softee trucks’ routes to poach customers. Plus, they didn’t have the special city license, which allowed them to operate without having to open storefronts or an office, and they could sell wherever they wanted.

Conway was too far away to help out as problems started cascading. Cai, meanwhile, had moved to the suburbs about an hour away and was starting another printed circuit board business, so had no time to lend a hand.

*   *   *   *

Perhaps the slashed tires and death threats were unique to Mister Softee, but local officials’ deciding to yank support was downright typical of the changing times.

For the record, nothing that happened to Mister Softee in Suzhou is “unique.”

The article then goes on to rightly note that foreign companies that bring technology or know-how that China hasn’t developed on its own are still very much welcome in China, but the others not so much. “One in four foreign businesses are scaling back in China or say they plan to, and most say they feel increasingly unwelcome, according to a 2018 survey from the American Chamber of Commerce in China.”

The article extensively quotes Anil Gupta, professor of University of Maryland’s Smith School of Business, “who’s been researching and writing about China for 25 years” and who has this to say:

Gupta added that blatant knockoff enterprises are so common in China that it’s almost a wonder Mister Softee’s easily replicated business wasn’t copied sooner. Plus, local officials and courts are more likely to back the local knockoffs to support Chinese businesses — to hell with the permits.

“With 99 percent confidence, I would say this was destined to happen,” Gupta said of Mister Softee’s fate. “I would say that God couldn’t even save this business.”

What or who exactly killed Mister Softee. China:

After receiving one-year permits for his trucks without fail from 2007 through 2012, Mister Softee’s permits were withheld without explanation and Sparks couldn’t reach government officials for months to clear up the issue. When Sparks finally heard back from government officials in mid-2013, they told him they would figure out a way to regulate the new trucks. Nearly a year later, with Sparks still operating without a new permit, officials proposed holding a lottery to dole out Suzhou permits to Sparks and the knockoff trucks. Around that time, police started ticketing Mister Softee trucks for parking illegally in spots they’d been working for years.

By 2015, it became clear the lottery would never take place and Sparks’s new round of investment crumbled.

“Part of it was a relief, to know it was over,” Sparks told me. “You feel, obviously, helpless.”

Over the next year, he wound down the business, paid his remaining staff and sold off the trucks so some others could spread the gospel of neighborhood soft-serve to nearby cities.

In early 2016 on a Friday, Mister Softee’s tumultuous foray into China quietly ended with Sparks, his lawyer, and accountant filing liquidation papers and figuring out who they still owed money to. Sparks had already sold off the office furniture to his ice-cream cone supplier.

Ignoring for a minute whether any deity could have saved Mister Softee, was there anything it could have done to survive China? Maybe. Were a company like Mister Softee come to me today, I would likely recommend that instead of going into business in China, it seek our a licensee in China for its name and its ice-cream know how and its trucks look and feel. Indeed, my law firm a few years ago did a licensing deal on behalf of a regional American ice cream that has worked out very well for the American company. I constantly find myself trying to steer clients away from what I call “theoretical massive profits” that can allegedly be realized by going into China as a WFOE or a Joint Venture in favor of a licensing or distributing deal. See Forming a China WFOE: Needed or Not. See also my Forbes Magazine on this: Want Your Product In China? Try Using A Local Distributor.

Welcome to China 2018 people.

What are you seeing out there?

UPDATE: Literally minutes after I wrote this I received an email from a China lawyer friend who said I should have talked about how Mister Softee could have prevented “at least some of its problems” by having made its employees sign non-compete agreements. I don’t think those would have worked because China’s courts generally will not enforce those against any but high level employees and I do not think ice cream truck operators would qualify as high level employees. See

the risks of doing business in China

As China governmental power continues to expand and continues to get more concerned about its slowing economy and how it is viewed by its citizens, it continues to get tough on foreign businesses. China is right now in one of its perpetual crackdowns on foreign companies doing business in China. This makes now a good time for foreign companies doing business in China or with China to determine their China risks. The following ten sets of questions are a good starting point for making that calculation.

1. How does the Chinese government view your industry? If your China business is in an industry in which foreigners are restricted (such as mining or publishing or education) or one in which China’s citizenry has major concerns (food and medicine are classic examples), your risk is likely to be high. If your China business is in an industry that requires you joint venture with a Chinese entity, your risk is also high. If your business is in an industry the Chinese government views as its own province, such as SAAS, cloud computing, the internet, or telecom, your risk is high. On the flip side, there are certain businesses (like the Internet of Things or IoT) China wants to encourage and so if your business comes within that sort of category, your risks will be reduced.

2. Are you in an industry the Chinese people consider to be their government’s responsibility, such as health care or education or environmental protection or food? A number of companies in these areas have been subject to government scrutiny for activities that probably would have been ignored in other industries.

3. Is your company primarily making money from China or spending money in China? If it is the former, you are at increased risk. Does your company have 20 foreign employees for every one Chinese employee? Your risk is high. Does your company have 300 Chinese employees for every one foreign employee? Your risk just went down.

4. Is your company based in the United States or exporting products to the United States? Your risk just went up. China is not particularly happy with the United States right now thanks to the US-China trade war. Equally important, you now need to make sure that any products you send to the United States truly come from the country from which you say they come. United States custom is checking almost everything coming from Asia these days and failing to properly label the products you are sending to the United States can bring huge penalties and jail time. See China Tariffs and What to do Now, Part 1 and China Tariffs and What to do Now, Part 2. See also China or Vietnam for Product Sourcing?

5. Are your China contracts written in Chinese for China? If so, your risks are lower. Or are you using English language template contracts written for a Western legal system (like the United States, Canada, Australia, or the EU)? If so, your risks are higher. See China Contracts: Make Them Enforceable Or Don’t Bother.

6. Do you know what your Chinese staff are doing? Chinese staff often fail to realize foreign companies are treated considerably differently in China than domestic companies, and they fail to act accordingly. Your Chinese staff will usually want to do things the “China way,” but the Chinese government and courts will be judged against the “foreign standard.” See China Compliance: Don’t Rely On Your China Staff. Do you think you can do whatever your Chinese competitors are doing? Your risk just went up. Do you believe that as a foreign company you will be more closely scrutinized and that the laws will be likely be enforced against you? Your risk just went down.

7. Are your China employment contracts and your employer rules and regulations in both Chinese and in English? If you answered yes, good for you; you have lowered your risks. See The Top Six Warning Signs of Impending China Employee Problems. Do you constantly update and audit your employment documents and procedures to make sure you are complying with all national and local employment laws and regulations? If so, you’ve greatly lowered your risks.

8. What have you done to protect your intellectual property from being lost in and to China? If you have the right contracts and the right IP registrations, you have reduced your risks. If you do not, you have increased your risks. See Protect Your IP from China Now not Later. Do you sometimes show your trade secrets to a Chinese company without first making the Chinese company sign a China-specific NNN Agreement? If you do, your IP is probably already gone.

9. What is the culture of your China business? If you are relying on “strategic” relationships to work around the letter or the intent of China’s laws, you are at greater risk. If you do not know well those with whom you are doing business, you are at greater risk. If things are happening that make you uncomfortable, you are at greater risk. If you believe things are happening at your company behind your back, you are at greater risk. If you know your company did not pay every RMB it should have paid in China taxes, you are at great risk. See China Tax Audits: The Day The Music Died.

10. Are you doing business in China without a Chinese legal entity, such as a WFOE, a Joint Venture or even a Representative Office? If you are, you are so off the charts on risk that you and your other personnel should leave China today or tomorrow. See Doing Business in China Without a WFOE: Will the Defendant Please Rise.

China’s government is surprisingly tolerant of problems a foreign company has already fixed, and even of problems a foreign company is truly trying to fix. But the Chinese government rarely tolerates a problem it discovers and about which the foreign company has done nothing. If you check out clean for the above list, congratulations. But if you do not, start making changes now.

China licensing lawyers

True confession. I have been writing too much about foreign companies looking to leave China and not enough about foreign companies looking to get into China. For the last few months, the work lives of the international lawyers at my firm have been inherently tilted towards those looking to leave China, rather than to get in. This is true for the following reasons:

  1. For every phone call or communication we get from a new client, we get 5-10 from existing clients.
  2. Existing clients do not call us to say “everything is going great in China, we’ll talk again soon.” That is not the nature of the lawyer-client relationship. No, they call us to say, “we have this problem in or with China, can you help us?”
  3. The overriding problem our clients have with China these days is the US-China trade war. It is important to note that this is true not just of our US clients, but of our European and Australian and Canadian and Latin American clients as well, because so many of those clients import made in China products into the United States.

But at the same time — and I actually this morning did the best I could with Clio and Lexicata (my law firm’s practice management and client intake software)– the number of companies contacting us to do business in China (including US companies) is much greater the first nine months of this year than the first nine months of last year — by every single possible metric. In other words, as one door is closing, another is opening.

I was reminded of this today after reading an article by Gordon Orr, entitled, Easier to Import into China? Quick aside: Gordon Orr is one of the 2-3 most knowledgable and most thoughtful writers on Linkedin and if you are not following him, you should go here and start doing so. His post needs no question mark because the answer is that it is easier to import into China today than last year and for many, cheaper too.

Orr answers his own question with “Two parts ‘YES,’ one part ‘NO,’ which translates for me to an overall “YES.”

Orr begins his article by discussing the “flood of announcements from China’s government” about how China wants to import more and of how it is moving to make imports easier. He then notes how China’s easing its lending requirements means Chinese companies are right now engorged with cash. All true.

Orr then notes how the following have increased and will continue to increase Chinese imports:

  • Streamlined customs clearance procedures to get product through at a faster pace. Investment at ports and airports will reduce logistical costs.
  • Actual tariff reductions from automotive to pharmaceutical will reduce end user prices by almost US$10bn with collected tariff rates falling to 7.5% from 9.8% last year. Tariffs for electronic equipment and machinery to 8.8% from 12.2%, duties for textiles from 8.4% from 11.5% and for paper products from 5.4% from 6.6%.
  • As trade ministers visit China, they are increasingly handed agreements to take back with them that open up access for products from their home market. For example, over the summer visits by Ministers from the UK led to announcements of the opening up of Chinese markets to UK dairy and beef products
  • Moves to make cross border ecommerce into China easier is an important move for many SMEs, for whom the cost of setting up to export to China has previously been prohibitive. The development of free trade “ports” to hold product in China duty free, the new ecommerce law holding the ecommerce platforms accountable for whether products sold on their platform are genuine, the upgrading of the teams within Alibaba and JD.com to reach out and market to potential exporters to China in dozens of countries globally have all helped SMEs to get to market at lower risk.

The bottom line is that now is a good time to be a seller of foreign products and services into China.

Our China lawyers are seeing how this import push is both directly and indirectly impacting foreign companies. The direct impact shows up with more foreign companies looking to sell into China and more companies seeing their China sales on the rise. The indirect impact shows up with more foreign companies doing brand and technology licensing and distribution deals with Chinese companies looking to leverage foreign technology and branding to their own Chinese customer base. Clio and Lexicata clearly bear this out as well, as our firm has (again, by every possible metric) seen a phenomenal increase in legal work for foreign companies doing licensing and distribution deals with China. We have even seen China be more encouraging of WFOE formations this last year than for perhaps a decade, both in terms of tax incentives and in terms of making the formation itself easier. China also recently liberalized its joint venture laws.  And just to be clear, we have neither heard nor seen American companies being treated any differently than other foreign companies on any of these fronts.

So yes, many foreign companies that manufacture in China are feeling pain these days, but foreign companies that sell in China or sell into China are thriving, perhaps like never before.

What are you seeing out there?

 

 

 

I got a badly written and vituperative email yesterday in response to my post, On the Impact of China Tariffs: Is This a Dead Cat Bounce? In my post I predicted a large decline in manufacturing orders from China, starting in the next few months. The email accused me of “hating China” and wanting “to impede its peaceful” rise and of being “jealous of its progress.” All this because we have been writing of late how so many of our law firm’s own clients and so many others are leaving China, or looking to leave China. We have been getting quite a lot of these sorts of emails lately.

Guess what people. Our post about foreign companies leaving China have nothing to do with our feelings regarding China and everything to do with what we are hearing and seeing. Our statements of fact about companies leaving China are not being made out of animus to China, but out of a desire to tell the truth and help foreign companies figure out what to do about China going forward. Life would be far easier and economically lucrative for us if foreign companies were not running for an exit from China. But from what we see, they are.

We are telling the truth about companies (not just American companies) looking to leave China because part of what we do is help companies legally fulfill their goals and their plans. My firm’s international lawyers help companies negotiate their exits from China and we help companies figure out where to go instead of or in addition to China. We also help companies looking to set up in other countries, do deals involving other countries, protect their IP in other countries, and draft necessary contracts in other countries. In the last few months our international lawyers have been being kept nearly as busy with countries like Vietnam, Cambodia, Indonesia, Thailand, Malaysia, Turkey, India and Pakistan as with China.

The above is but an introduction to what we see as China’s diminished future for foreign companies. Since pretty much the inception of the US-China trade war we have been saying that we do not see its end because we have always seen it as more than a trade war. At first, we saw the US tariffs as an effort by the United States to get China to “open up” and “act right” on things like the internet and IP. But because we did not see China changing on these things, we did not see the trade war ending.

Vice-President Pence’s speech on China earlier this week has only reinforced for me that the trade war between China and the US will not be ending any time soon, if ever. The New York Times has called that speech the Portent of a New Cold War between the United States and China and China’s own Global Times wrote an article entitled, Pence speech shows Washington’s tougher policy on China. Don’t blame us. We are just the messengers. Things are getting very tough between China and the United States right now and the trade war is just a symptom of that, not the disease.

The United States is aggressively and unabashedly doing what it can to isolate China and to remove it from the world of international trade. The new free trade agreement between the United States and Canada is further proof of this as it essentially blocks Canada and Mexico from engaging in free trade with China. See What Trump’s new trade pact signals about China. Word is that shutting out China is going to become a regular thing in all new U.S. trade agreements. See US Commerce’s Ross eyes anti-China ‘poison pill’ for new trade deals. Will the EU and Japan and Latin America play ball on this? I predict that most if not all of them will.

So yes, the above is why we will continue to write about what North American and Latin American and European and Australian businesses should be doing to deal with the new normal regarding China. We are writing these things because we value our credibility and because we presume our readers value our no-holds barred advice — threatening emails or not.

For more on the new normal, check out the following:

And just in case you still believe we are saying the above for political not business reasons, here is your palliative: a great book that asserts the United States is blaming China for the US’s own ills: Blaming China It Might Feel Good but it Won’t Fix America’s Economy, by Ben Shobert, a good friend of mine. Ben — what are you seeing out there in terms of companies looking to leave and/or leaving China? 

What are you-all seeing out there?

So far nobody has written to factually dispute that many (most?) foreign companies are looking to leave and/or are leaving China, but we certainly would welcome such information if you have it! 

UPDATE: An international lawyer friend just sent me a link to this blog post by Renaud Anjoran over at the Quality Inspection Blog. Renaud heads up a top-flight quality inspection/product sourcing company out of Shenzhen, China, but his post was written from Vietnam and is entitled Transferring Production from China to Vietnam to Avoid Tariffs. Renaud’s post is essentially a how to on moving production from China to Vietnam. Does anyone believe Renaud went to Vietnam and wrote this post for reasons other than because his clients too are looking to reduce their dependence on China?

 

China employment law firm
Change your mindset for China employment contracts.

If you have or are going to have employees in China, you need a China-centric written employment contract with each of your employees. Around once a month, one of our China employment lawyers will get a company asking us to “translate our existing employment agreements into Chinese for our China office.” Our response to this request is always the same: “Sorry, we cannot do that because the end result will not work at all for China. You need a China specific employment agreement and our translating what you are using (in the United States or the UK or Canada or Australia or Spain or France or wherever) is not going to work.” At all.

I want to be very clear: translating a foreign country employment agreement into Chinese for use in China is a flat out dangerous thing to do. Even if your translation is perfect and it captures everything you want it to say (which seldom happens), an employment agreement not written specifically for China will contain provisions that do not comply with China’s employment laws or are unworkable in your specific locale in China. For these same reasons, our unwillingness to “just translate a contract into Chinese” extends to every contract we do. See Translate Your Contract For China? The Answer is No.

The most common example our China employment lawyers see in foreign employment agreements of something that will not work under China’s employment system and that can be harmful is a provision stating that the employment is at-will. Under an employment at-will system, an employer is said to be able to terminate an employee for good reason, bad reason or no reason at all, but in China, terminating a China employee almost always requires specific cause both allowed under China’s national and local employments laws and under your employer rules and regulations. Putting an at-will employment provision in your employment agreements will not help you but it can hurt you by making your China management team believe they can fire their China employees for any or no reason at all. We have seen many wrongful termination actions brought by employees terminated by managers who believed they could do so at-will.

If you now think that merely eliminating any references to at-will employment will solve the translation problem, you’re dreaming. China’s entire employment law system is very different from those in Western countries and this necessitates very different employment contracts across the board.

Take overtime pay as another example. If your China-based manager is working under the standard working hours system (this usually means 8 hours on a work day and 40 hours in a week), you must pay or otherwise compensate him or her for any overtime incurred. See China Employee Working Hours and The Things You Cannot Skip. If your manager has been approved by the government to work flexible hours, you may be able to avoid paying overtime, but not always. The foreign country managerial contracts we see usually contain a provision making clear there will be no overtime. If one of your China managers sues you for unpaid overtime in China, you should expect this provision will be Exhibit 1.

Many foreign companies have their own policies on how much notice their employees must give when resigning and these sort of notice requirements are often put into their employment agreements. China though has its own very strict notice requirements and an employer that seeks to require resignation notice longer than China’s own minimum requirements is just asking for legal trouble.

We have also found that using a non-China centric employment agreement causes companies to lose sight of what most matters for China. Seniority, for example, is a huge issue for China employees as it is tied to other important employee benefits, such as statutory vacation days, and statutory severance. It is therefore important as a China employer that you deal extensively and clearly with this issue in your China employee contracts. But because this issue is usually not covered or covered very differently in foreign employment agreements, your using your foreign employment contract as your template for your China employment contracts will mean you either fail to address this critical issue or you will do so very badly. Either way, this will end up hurting you if/when you are sued.

This is not to say that what you have in your existing employment contracts is wholly worthless in formulating your China employment contracts because it isn’t. My firm’s China employment lawyers will often like to review our clients’ existing employment contracts before we start drafting their employment contracts for China. We though want to see those contracts not because we intend to translate them or even because we intend to use them as a template for the China contracts. Rather, we want to see them just because they often broadly outline what is important to our client in its employer-employee relationships.

In terms of your own thinking though, it is best for you to start from scratch. China employment laws are that different and that local and so what you know from Barcelona or Boston or Brisbane or Berlin may not matter or may just get you in trouble.

Forming a China WFOE
Forming a China WFOE is not kids play

If I were to list the ten biggest/most common mistakes the China lawyers at my firm see committed by foreign companies doing business in China, not forming a WFOE and forming a WFOE unnecessarily would no doubt both be on that list.

Let me explain….

We have written constantly about the risks of doing business in China without a WFOE. For more on that, check out the following:

Today’s post is going to focus on the mistake of forming a WFOE in China when no such WFOE is actually necessary or advised, an incredibly common and very expensive mistake.

It is expensive and time consuming (usually 3-5 months) for foreign-owned businesses to be formed in China. The following is the most basic list of what you need to do to form a Chinese WFOE and then operate it legally and safely in China:

  • Determine whether your business model is legal for a foreign business in China.
  • Form and register your WFOE in China. This will typically be a WFOE, a Representative Office, or a Joint Venture.
  • Lease property (a prerequisite for the registration process above).
  • Draft an employee manual and execute written employment agreements with all of your employees.
  • Open a bank account with a Chinese bank.
  • Figure out and pay all of your taxes, including company taxes, employee taxes, and social insurance payments for your employees.

It is complicated and expensive to form a WFOE in China and it is complicated and expensive to operate a WFOE in China. Very. To do so in most cities, you need good office space and you need employees and you need to meet with the tax authorities four times a year and you need to calculate and pay all sorts of taxes and….

To make matters even worse, shutting down a WFOE makes forming one seem like a piece of cake. See Closing Down a China WFOE: You Can Run But You Can’t Hide (Part 1) and Closing Down a China WFOE: You Can Run But You Can’t Hide (Part 2). Let’s just say that I once heard a China accountant at a seminar analogize it to a colonoscopy. Not kidding.

Because forming a China WFOE is very expensive, there are scads of companies in every tier 1 or tier 2 China city that exist solely or mostly to form China WFOEs. This means that if you go to one of these companies to form a WFOE the odds of them telling you that you do not need a WFOE are slim to none. The odds of them questioning you on why a WFOE might or might not make sense for you and then analyzing whether it does or does not are about the same.

The result of this is that countless foreign companies go through the pain and expense of forming a WFOE they don’t need, then operating a WFOE they don’t need, and then closing down a WFOE they never needed in the first place. Ugh.

Even worse are the entity formation companies that encourage foreign companies to start with a Representative Office that the foreign company does not need and then a year or two later encourage that foreign company to shut down that Rep Office because a WFOE is now allegedly needed and then charge for shutting down the Representative Office and for forming the new WFOE. This allows the entity formation company to charge for two additional processes that were never needed in the first place — forming and shutting down the Rep Office. Ugh. Note: Rep Offices cannot directly employ anyone nor can they get paid in RMB and just to give you an idea of the utility of China Rep Offices, we have not written about them since 2013!

My law firm and most law firms (both foreign and Chinese) do not play these tricks. What we do before forming any company in China (WFOE or otherwise) is to determine whether any such company makes sense at all. In Forming A China WFOE: The Agony and the Ecstasy, I wrote the following:

At least once a month, one of our China lawyers will get a call from someone asking us to form a “China company” for them before they start doing business in China “next month.” Half the time when we get this sort of call, the better solution is not to form a China entity at all.

That “half the time estimate” is still true but I should also mention that many times when our China lawyers get a call from someone having a problem with their WFOE, additional discussion reveals they should never have formed their WFOE in the first place. Ugh.

Do YOU need a China WFOE? Generally speaking there are two main situations when a China WFOE is legally necessary and a third situation where it can make good sense to have one, even though not legally required.

It is legally necessary to have a China WFOE (or some other legal Chinese entity such as a China Joint Venture) if you will have one or more employees in China. Note that you should assume that anyone you are paying in China as an “independent contractor” is in fact an employee. See Four Common and Dangerous China Employee Hiring Myths, in which Grace Yang, my firm’s lead China employment lawyer, lists “Hiring without a Chinese legal entity (WFOE or Joint Venture) is fine so long as you only bring on independent contractors.” as Myth 1.

It is also legally necessary to have a China WFOE (or some other legal Chinese entity) if you are going to get paid in RMB.

If neither of the above are or will be true for you, you probably do not legally need a WFOE.

There are though many instances where a WFOE is not legally required yet forming and having one still makes sense. If you sell products or services to universities, banks, hospitals, governmental bodies, SOEs or Chinese businesses with any sort of governmental ownership it might make sense for you to have a WFOE, even if you are not legally required to do so. These sorts of businesses are often pressured by the Chinese government to buy from Chinese entities and if you don’t have a WFOE your sales could be way less or non-existent. We also have seen instances where having a WFOE is worth the money and pain because it increases sales by convincing Chinese buyers that you are in China to stay and that there will be someone local to whom they can go if ever they have problems.

But just to complicate things even more, our China lawyers often see instances where a foreign company formed a China WFOE to hire employees in China and/or to get paid in RMB in China and yet would have been better off without having done so. These are cases where the foreign company did not realize that it had better options for accomplishing its China goals without need for a China WFOE. The following are the two most common examples we see of this:

1. Foreign company forms a WFOE in China to sell its widgets. Foreign company hires two employees in Shanghai to do this after having been convinced that it needs a WFOE because it will have employees in China and because it will be getting paid for its widgets in RMB. In Want Your Product In China? Try Using A Local Distributor, an article I wrote for Forbes Magazine, I emphasized the benefits of selling widgets to China through a distributer, rather than going it alone:

When foreign companies want to get their products into China, they often think they only have two choices: go it alone via a China WFOE or form a joint venture with a Chinese company.

Joint ventures are notoriously risky, while a WFOE can take three to five months to form, leaving you with a company in China to operate (that includes bookkeeping, hiring employees, etc.).

But there’s actually an easier option. Companies can enter into a distributorship relationship with a Chinese company (or companies).

Use a Chinese distributor

From a business perspective, taking most products into China (be they industrial or consumer) is a massive task for any foreign company. China is a big and diverse country and it should be viewed as many markets, not just one. Using an experienced Chinese distributor is oftentimes the best way for to sell your product in China.

And from a a strictly legal perspective, distribution (and reseller) relationships between foreign and Chinese companies are fairly straightforward.

Distribution contracts with Chinese companies can have much in common with U.S. distribution agreements, but they also almost always also have stark and important differences.

Licensing your brand name and/or your technology is another excellent (and far less risky) way to profit from China without setting up and operating a WFOE there. See China Technology and Trademark Licensing Agreements: The Extreme Basics.

2. Foreign company forms a WFOE to hire one or two people to handle its China quality control. There are many very good and very inexpensive QC companies in China and oftentimes that is a better way to go. And here’s the thing. Oftentimes if you want a QC person in each of the two or three cities in which you are having your products made, you need to form a separate WFOE (or at least a branch office) to be able to legally hire employees in all of those cities and then deal with China’s highly localized employment laws.

Bottom Line:  Forming and operating a WFOE in China is difficult and expensive and you likely have all sorts of other options. It would behoove you to explore those options before you form your WFOE.

China attorney

In 2012, I wrote an article for the Wall Street Journal, entitled, China’s Slowdown and American Business. There was a slowdown happening in China at that time and the China lawyers at my law firm were “feeling it” from the emails and phone calls we were getting from foreign companies doing business in or with China. My WSJ article sought to address the issues our lawyers were seeing back then. Since that article, China has gone through intermittent slowdowns and during each of those we see pretty much the same same issues each time. Because China is again going through an economic slowdown — due in large part to a trade war that is only going to get worse– I thought now would be a good time to reprise that article and write again about how to handle a China economic slowdown. For more on China’s economic slowdown, see this CNN article from today, The trade war is deepening the gloom at Chinese factories.

China lawyers
China’s Economy is Slumping

The Wall Street Journal chose the following subheading for my 2012: “Hardly a week goes by without complaints about payment problems or bankrupt debtors.” If I were to choose a new subheading for this post today, it would be “Hardly a day goes by without complaints about getting  bad product and hardly a week goes by without someone asking about what will be required for them to shut down their China WFOE.”

The following are the key points from my Wall Street Journal that apply with at least equal force today:

Regulation. The best assumption to make is that the Chinese government will respond to the slowdown by attempting to minimize citizen discontent so as to keep its hold on power.

Sourcing Problems. The slowdown is changing Chinese company interactions with foreign companies. Chinese exporters, particularly those that compete with companies from lower-wage countries like Vietnam and Bangladesh, are suffering—in particular in low-tech, low-wage industries such as textiles, clothing, shoes and low-end electronics and toys. Foreign companies that do business with Chinese companies in these industries must be on their guard. Hardly a week goes by without one of the China lawyers at my firm getting a call from a Western company experiencing problems. Sometimes the Western company has paid for a product and the company it paid no longer exists. Sometimes the company still exists but it needs “more money” from the Western company to buy raw materials for the product it already promised to produce.

Foreign managers need to understand what is happening in their own industries within China. This might mean visiting your Chinese factory, warehouse or office to look for warning signs of a company in distress. Or it might mean taking out insurance to cover your China business or transaction. A number of Chinese manufacturers are owned by Taiwanese, Singaporean or Hong Kong companies, and sometimes it is possible to secure guarantees from the foreign parent.

The key is to be proactive: If you find yourself in a bad situation with a Chinese company going under, there usually is no remedy after the fact. Bankruptcy in China more often than not consists of a company shutting down in the middle of the night and its owner fleeing to another town.

The key to weathering China’s slowdown will be for foreign companies to go back to basics …. focus on scrupulous regulatory compliance; and renew focus on due diligence at a company-to-company level. Above all, no Western company doing business in China should blithely assume that a slowdown won’t affect it.

Updating the article, the biggest change from 2012 to today is the massive increase in Chinese companies willing to risk their relationships with the very same foreign companies with whom they currently do business. We wrote about this previously in Your China Factory as your Toughest Competitor. But it is now not just factories; our China lawyers are seeing this in all industry sectors, especially technology. Our China lawyers have become fond of pointing out that “since you will essentially be educating your Chinese party in how to compete with you, you need contracts that will at least limit what they can do when they do so.”

Why are China companies now so willing to risk losing out on business with existing customers to go into business competing with them? When times are bad, greater risk becomes necessary to pay employee wages and to stay alive.

China’s manufacturing sector has taken a hit from migration of international business to lower wage and cheaper countries across South East Asia. Since President Trump’s first round of tariffs, our international manufacturing lawyers have seen a near 50% increase in work involving Vietnam (mostly), Indonesia, India and Malaysia. And with one or more of these countries coming up in so many of our conversations with clients, we are quite certain this migration to SE Asia will only increase, no matter what happens on the trade war front. With manufacturing moving elsewhere, many Chinese companies rightly believe they need to do something different and heir seeking to compete with their own customers is that something different.

We are getting at least two calls/emails every week from companies seeking help in trying to remedy/stop their Chinese suppliers from using their molds or their information or their customers to compete with them. We have gotten more calls in the last three months from companies whose China factories are now directly competing with them than in probably the three years before that combined. Chinese factories are more confident and willing now than they have ever been about going out into the world with their own products, and more willing to toss their foreign customers to the curb early. In nearly all instances there is little we can do. Though it might be possible to sue these Chinese companies, without rock-solid China-specific contracts in place, such lawsuits seldom make economic sense. See China Contracts: Make Them Enforceable Or Don’t Bother.

China lawyers fraudMost of what we write about frauds involving China usually are frauds perpetrated by Chinese companies against foreign companies. But as a reader recently pointed out to me the other day, frauds perpetrated within foreign companies “are at least as common and as damaging.”

I agree, and today’s post highlights six of the most common frauds our China lawyers see.

Before I talk about internal company fraud, I want to quote a long-time client and friend on how to deal with these. This person is from Europe but his “business empire” extends pretty much around the world and it includes some extremely difficult places in which to do business — places that make China look like a piece of cake. Once when I told him that I was convinced that people in one of his business (in a country usually prefaced with the words “war-torn”) were skimming fairly large amounts from his company his response was something like the following:

My goal is not to stop all internal theft as that would be impossible. My goal is to keep my eye on the prize and the prize is to maximize profits and to succeed wildly. And so as much as I hate company theft, my cracking down on it has to come at the right time and in the right way. I am not going to decimate a booming business by firing those who helped me build it even if they are stealing from me. In the meantime though, if you think you know who is stealing from me, let me know so that I can act when the timing is right.

I have used the “keep your eye on the prize” line at least 100 times in various speeches and I especially like that line when talking about stopping counterfeits. See How to Protect Your IP from China.

When it comes to internal company fraud, this means it is critically important you do whatever you can to prevent and/or root out the sort of fraud that will destroy your company, but far less important that you stop employees taking home pens. What to do with the far more common in between sorts of frauds is going to depend on the specific nature of your situation.

In any event, here are the top six China internal company frauds:

1. No real company. No real employees. This one was incredibly common ten years ago, but far less dangerous then. It is less common today but far more dangerous. See Doing Business in China Without a WFOE: Will the Defendant Please Rise. With this fraud, your “general manager” or someone else with a lot of power will charge your company to set up a China WFOE and then for years acts as though you have a China WFOE, but you don’t. The spoils from this fraud can be huge and ongoing. Suppose your WFOE generates $4 million in income a year and pays $1 million to its “employees” in salary. If there were a real WFOE, China income taxes would be around $800,000 a year and employee taxes and benefits would be another $400,000 or so. Now imagine this “WFOE” does not exist and so it also has no real employees. Someone other than your company is now clearing about $1.2 million a year by not paying taxes. Even worse, at some point (likely very soon in light of the harshest crackdown ever against operating in China without a legal entity) your fake WFOE will get shut down by the authorities (and rightly so) and you will then get hit with a massive tax bill that includes back taxes, plus interest, plus penalties, plus worse. See China’s Tax Authorities Want You.

How do you spot this one? We have had a couple companies come to us after learning that their general manager was living in a multi-million dollar condo and driving a $100,000+ car on a salary that could in no way sustain such a lifestyle. This is one way to spot this fraud, but the better way is to do the research to confirm your China WFOE is in fact a China WFOE and that all of your WFOE “employees” are in fact WFOE employees.

2. Overstated or Understated Income. Not sure which of these two is more common but they both happen fairly often. Overstating income is usually done to meet performance goals or to prevent a company from being shut down. Understating income is usually done to hide that someone is improperly taking money from the company. Overstated income can mean your company sinks money into an enterprise it probably should abandon. Understated income means you owe taxes and interest and penalties of which you were not aware. How do you stop these? Financial audits, financial audits, financial audits. It also helps to have someone in your company who cares about and understands what is happening in China and this usually comes from visiting the China WFOE often.

3. Friends and Relatives and Side Companies. Using friends and relatives as your China WFOE’s suppliers and paying more for the “privilege” is incredibly common. If the friends and relatives suppliers are charging 1 to 5% more you may never catch it and it may not be all that big of a deal if you don’t. But when our China lawyers are brought in on these situations, we typically see more like 30 to 50% in up-charging. I cannot tell you how many times we have worked with an American or a European company that terminates its China sourcing agency only to learn (usually from the factories that were actually making their product) that in addition to the 5% fee it knew it was paying its sourcing agent, it also was paying a 40% skimming premium. See Hidden commissions between China factories and sourcing agents. Even more common (at least in terms of what our China lawyers see) are outside companies set up by your own general manager. How do you stop these fraudulent supplier deals? You monitor pricing and you monitor who owns your suppliers. You also need to be very clear in your Employer Rules and Regulations (and pretty much every other place possible) that you will not tolerate supplier fraud.

4. Bribes. This one is too multi-faceted and complicated and important for me tot cover in the depth it deserves so I will opt to be incredibly brief. Bribery is bad for your business and you need to do what you can to prevent it. China Bribery: Not Smart and not Necessary.

5. Side Door Sales. This fraud is very profitable and hence very common. Imagine you can charge $800 for a widget which cost you literally nothing to develop or make or market. Imagine also that you have people calling you every day to buy this product. Now imagine that one of your employees is doing this with your product. We see this sort of thing most often in the following two situations:

  1. The China WFOE makes and sells a product all within China, or it makes the product in China and sells it to SE Asia or to some other emerging market country not so much on the foreign company’s radar.
  2. The China WFOE is in a business where it both buys and sells a product. As an example, a fish brokerage company that buys fish in China and then sells that fish worldwide might have an employee who uses company assets to buy $500,000 worth of fish and then sells that fish for $525,000 and then pays everyone back without anyone ever being the wiser. Or what if your employee is in cahoots with an employee at the fish company and they do the deal without any money even changing hands until your employee gets paid? What if your employee is siphoning off 50% of your business with this scheme? What if your employee becomes so successful at it that he or she no longer needs your money to do these transactions because he or she has built up its own funding, but he or she keeps using your good reputation and your marketing dollars to further his or her own business? What is amazing about this fraud is that nearly every time this sort of employee is terminated he or she already has a company set up to ready to compete against the foreign company a day or so after the termination.

How do you stop this sort of fraud? With Employer Rules and Regulations that make clear this will not be tolerated. With non-compete and non-solicitation agreements/provisions that prohibit this. And then you sue.

6. Fake Employees. Would you know if your China WFOE had 200 employees, not the 250 employees to whom it is allegedly paying salaries and benefits? If you answered in the negative to this, you should do something immediately so you can answer positively the next time because putting non-working friends and relatives on payroll is a classic China fraud. This one is particularly commonly used by Chinese companies in China Joint Ventures to zero out profits so there never have any profits that need to be shared with the foreign JV partner.

What are you seeing out there?

China WFOE formation

I do mean to sound alarmist here.

Almost since this blog’s inception, we have written about how if you are doing business in China you need a Chinese legal entity, be it a Wholly Foreign Owned Entity (WFOE), a Joint Venture (JV) or a Representative Office (RO). And pretty much each time, our writings on this get more emphatic and more strident. Today they reach a whole new level. Today we warn you about jail time because that is what we are hearing is happening in China right now.

In the last two years our stridency on this issue has gone into hyperdrive. Today I want to SCREAM that if you are doing business in China without a Chinese legal entity you should probably leave China immediately and consider what to do in China from the safety of your own country.  I will explain why I am saying this shortly.

In March of 2017, in Doing Business in China with Deportation or Worse Hanging Over Your Head, I had the following to say:

We have frequently been writing of late on how China has like never before been tracking down foreign companies (especially U.S. companies) that are operating in China without having a business entity (a WFOE or a Joint Venture) that allows them to legally do so. See Donald Trump and Your China Business: Double Down, Ditch It or Die and Donald Trump and Your China Business: Double Down, Ditch It or Die, Part 2. In China’s defense (not that its decision to rigorously enforce its own laws needs any defense), the new WFOE formation rules enacted last year do actually make it somewhat faster, cheaper and easier to form a WFOE.

Anyway, since we started hitting this issue hard here on the blog, we have gotten an even greater stream of emails from people who have been “caught” by the Chinese government and from people who want to know what exactly they need to do to get legal. But the most interesting emails come from those who either fully or partially refuse to believe what has been happening in China and how at risk they are. About half of the emails sent to our China lawyers evidence at least some aspect of this and about half of those mention forming a company in Hong Kong as an option for solving all problems.

So let me say right here and right now that forming a company in Hong Kong will not do a thing to make you legal in Mainland China. Nor will forming a company in Macau or Taiwan or Singapore. If you are doing business in the PRC/Mainland China, you need a PRC legal entity, such as a WFOE or a Joint Venture. See Having A Hong Kong Business Does NOT Make You Legal in Mainland China. See also A Hong Kong Company Is NOT a Mainland China Company and a Hong Kong Trademark is NOT a Mainland China Trademark. If it were otherwise, virtually nobody would go through the agony and the costs of forming a WFOE; they would instead pay some accountant in Hong Kong about USD$1,000 and have an HK company in less than a week. Please, please, please do not fool yourself into believing otherwise!

The below email is an amalgamation of two emails I received just this morning, both involving people with United States and Taiwan passports.

I came across your law blog and would like to ask a question. I’m in a slightly strange situation, professionally and nationality wise, and I I wonder if you might be able to offer me guidance.

I am a US/Taiwan dual national living and working as a freelancer in Shanghai, which is my base. I work in the _________ business on a contract-to-contract basis. Though my Taiwanese friends are always telling me not to worry about things like taxes, the more established and successful I become, the more I think I should be figuring out how to get legal in China and make myself legitimate, business-wise.

I am a ________________ and I do other related things. For example, I’ve just been asked to __________ on a relatively large project. Sometimes I am paid in RMB and other times I am wired foreign currency to accounts I hold overseas. Sometimes because I am not a legal business the companies I work for negotiate discount rates from me because my not having a China company precludes them from getting a tax deduction for their payments to me.

As I progress professionally, the amounts I charge and get paid keep increasing and I worry about what all of this means for the long term.

A friend has suggested I go to Hong Kong to set up a WFOE. However, I know some of the rules are different for Taiwanese nationals who wish to set up businesses in China.

It is not my ambition to have a big company or service but I also know that this gray area situation may not be sustainable forever. I also want to know if any of this might affect me as a U.S. citizen. At the moment, I just file federal taxes online.

Please let me know if you have encountered cases such as my own, and if you might be able to point me to resources that would enable me to best formalize my situation.

Many thanks.

Our response is always something like the following:

Setting up a company in Hong Kong will not help you one bit in terms of getting legal in China. You need to re-think what you are doing because as you get bigger you become a bigger target. I do not know how China treats Taiwan citizens, but if you are an ethnic Chinese there on a US passport, you are probably at the top of the list. My advice is that you start doing something and fast. You should consider either leaving China or setting up a WFOE in China that employs you. If you leave China you can do some business in China without triggering the need to have a WFOE in China, but because you provide services there, you will still be required to pay income tax there. So long as you are paying your United States taxes, the U.S. very likely does not care what you are doing or where you are doing it; your big concern should be the PRC, especially since you live there. The bigger you get, the more likely it is that someone will rat you out or that you will be noticed by the Chinese government. Productive legitimate businesses do not operate with this sort of hammer poised to hit them on the head. What you should do is weigh the various costs and benefits of your various alternatives and decide on one.

Then just last month, in American Companies in China without a WFOE and the Impact of Donald Trump and US Tariffs and Why Hong Kong is not the Answer I wrote again how American companies are at increased risk of serious trouble for operating in China without a WFOE:

If you are an American company doing business in China, you don’t need me to tell you how so many things have changed for you over the last year or so, and so I won’t.

But I do need to tell you — somewhat urgently — that if you are operating in China without a legal Chinese entity, you need to stop. Like right now.

Back in March, we did a post, Doing Business in China with Deportation or Worse Hanging Over Your Head in which we discussed how “China has like never before been tracking down foreign companies (especially U.S. companies) that are operating in China without having a business entity (a WFOE or a Joint Venture) that allows them to legally do so. See also Donald Trump and Your China Business: Double Down, Ditch It or Die and Donald Trump and Your China Business: Double Down, Ditch It or Die, Part 2. Our thesis — based on what we were seeing on the WFOE front and on other crackdowns involving even things like bar fightsvisasexpat taxescannabis, and employment law — was that China was toughening up enforcement against foreigners and foreign companies in China on all fronts, but especially against Americans and American companies as a sort of a slow and not terribly public retaliation against President Trump.

With all the talk now about US tariffs against China, legal enforcement in China against American companies operating in China without a WFOE has gone into hyperdrive. One of our readers, herself a China lawyer, recently wrote me to let me know how ridiculous she thought I was for believing Beijing would “quietly” go after American companies. My response to her was that we had no idea whether China’s stepped up legal enforcement is being directed from Beijing or is more in the nature of a slow and quiet and yet widespread uprising against the United States being mounted by government officials throughout China.

We can debate who is leading this enforcement charge and even the reasons for it, but to me the most important thing is that if you are an American company and you are not in full compliance with Chinese law you are at greater risk now than you have ever been. If you are doing business in China, especially if you are doing business there “through” a Chinese citizen you are paying, you need to think long and hard about your China company formation options.

Whenever we write about how China is getting tougher with such and such a law, we invariably get emails and/or comments saying how idiotic and/or unfair we are for criticizing China for enforcing its laws. Just so the record is clear, we have not said that and we are not saying that; we are as neutrally as possible merely writing on what we are seeing and we would be more than happy to leave it to the legal philosophers to put these sort of real-life China business and legal issues into some larger context.

In addition to the stepped up enforcement of China’s WFOE requirements, we are also seeing a massive uptick in American companies forming Hong Kong Companies or consulting WFOEs in ill-advised efforts to get legal. So let me use this blog post to once again make clear, forming a company in Hong Kong does not do a thing to make your business operations legal in Mainland China:

Nor will forming a company in Macau or Taiwan or Singapore. If you are doing business in the PRC/Mainland China, you need a PRC legal entity, such as a WFOE or a Joint Venture. See Having A Hong Kong Business Does NOT Make You Legal in Mainland China. See also A Hong Kong Company Is NOT a Mainland China Company and a Hong Kong Trademark is NOT a Mainland China Trademark. If it were otherwise, virtually nobody would go through the agony and the costs of forming a WFOE; they would instead pay some accountant in Hong Kong about USD$1,000 and have an HK company in less than a week. Please, please, please do not fool yourself into believing otherwise!

In fact, the more you get on the grid in China without actually doing everything the right way in China, the more you make your illegality more obvious and easier to spot. See Quasi-Legal In China. Not the Place You Want to Be andQuasi-Legal in China. Not the Place You Want to Be, Part II.

We are also hearing from many American (and some European companies as well, but we’ll save that for a subsequent post) companies that formed their WFOE in China the “fast and easy way.” Some less than reputable WFOE formation companies will tout how they can form China WFOEs quickly and cheaply and for only around USD $15,000 in minimum capital. What these WFOE formation companies typically then do is form your company as a consulting WFOE in an “easy” China city. Please don’t fall for this. If your WFOE is not going to be in the consulting business, it cannot legally operate as a WFOE in China and it will get shut down. See How To Form a China WFOE. Scope Really Really Matters, Part II. And if your WFOE is going to be operating in Xi’an you do not want it to be formed in Shenzhen, for just a whole host of reasons.

If you are not complying with Chinese laws it is important you move quickly to get into compliance. But it is also important that in moving quickly you not expose yourself to even more and potentially greater problems. To borrow from a famous legal quote, you should move to get legal in China with all deliberate speed.

China company formation done wrong is not going to be your answer.

Today I write to say that things have reached another level for people of all nationalities doing business in China without a legal entity. Today I write to say that doing this — whatever your nationality, puts you at extreme risk of being arrested and put in jail. I cannot go into much detail but I can tell you that over just the last three days I have heard of three instances (in three different Chinese cities) where foreigners (from three different countries) were put in jail for operating in China without a business license and failing to pay taxes on their China income. Jail. Prison. The clink. The slammer. The real thing people. The real thing. One of these cases also involves vague allegations of custom violations, claims for which the Chinese government has never been shy about imprisoning foreigners. See China Customs Violations and How to Avoid Jail Time.

Why are these arrests happening now? I posit the following two explanations:

  1. The arrests are happening because China is concerned about its economy and/or its general situation in light of US trade tariffs.
  2. The arrests are happening as just another “stepping up” of China tax collection efforts.

Again though, these arrests are not just of Americans. It is so early in the criminal law process that it is not clear to me how serious these charges are against those arrested. Will they merely be deported? Have they been arrested with the goal of getting evidence against others? What is it going to take for these people to be freed? Will paying off their taxes with interest and penalties be enough to get them released? See China’s Tax Authorities Want You. Will paying some part of the taxes be enough to get them released? What taxes are being pursued? Income taxes? Employer taxes? Both? Most importantly, is China serious about putting these people in jail for an extended period and if so, for how long.

No matter what the reasons for this most recent and most alarming crackdown, if you are in China right now and if you believe you or your company might be operating in China without a Chinese company when you should have a Chinese company, if I were you I would leave China quickly. I just would. And if you do get detained on your way out, you should as quickly as you possibly can retain a top-tier Chinese criminal lawyer in the city in which you arrested.

That is all. Sorry.

 

UPDATE: A loyal reader emailed me to note how this is the second day in a row that we have warned people not to do something at risk of going to jail. Yesterday, in China Tariffs and What to do Now, Part 1, I passed on advice from my law firm’s international trade lawyers regarding the criminal risks relating to changing the country of origin via transshipping to avoid the tariffs the US is imposing on products from China. This reader pointed out how the devolution of free trade is increasing the risks for companies that operate internationally. I agree with that assessment, but note that it is particularly true for those who are not careful and who are willing to operate close to the line between legal and illegal. Your thoughts?

ADDITIONAL UPDATE:  A Chinese lawyer friend of mine sent me an email stating that “the point here is that operating in China without a WFOE is illegal. This also applies to Internet/SaaS operations operating in China illegally, and you and I both know plenty of those. So long as the operators of these illegal Internet/SaaS operations stay out of China, they will avoid jail. But what about their partners who are operating in China? And what about when they take a two week business trip to China to check up on the situation there? Do you think companies really understand the fire they are playing with here?”

China WFOE formation and business scopeWhen it comes to company formations, China is from Mars and the Western world is from Venus. For most things related to doing business in China, I often stress the similarities. But when it comes to forming a China Wholly Foreign Owned Enterprises (WFOE) I make it a point to stress the differences. I do this early by stressing how when all is said and done, forming a WFOE in China typically costs more than ten times what it costs to form an LLC or a corporation in the United States or in Europe and usually takes at least ten times longer as well.

I then joke how our domestic business lawyers in Spain and in the United States barely care what they charge for forming companies in those two countries because their overriding goal is to bring in a client for life and then help the client with everything that comes after — on things like contract law work, intellectual property law work, tax law work, real estate law work, employment law work, immigration law work, and more so lately, even international trade law work. Forming corporations and LLCs is essentially a loss leader, made up for later with an onslaught of work typically needed once the company is up and running. Then I half-joke about how forming a WFOE in China is so miserable that by the time our lawyers finish that task “you will be so sick of us, you will never want to use our China lawyers ever again.” I then mention that you very well may not even need to do so.

Why so different? Very briefly, in the United States and to a certain extent in Spain as well, registering and establishing the corporate entity is relatively fast and easy; most of what is difficult comes later. In China though, registering and establishing an entity like a WFOE for the most part cannot be accomplished without doing the hard slog work first.

I will over the next few weeks write more about what must be done to form a China WFOE and why doing so is so difficult and time consuming and different from forming a company in the West. Today though, I will focus on the business scope of the WFOE you will be forming.

What exactly is business scope? Think of it as what your company will be legally allowed to do. When it comes to forming a company in Spain or in the United States, scope is more of an afterthought than anything else. Guess what. This is absolutely not true of China. In the United States, if you want to form a company that will sell men’s clothing at the front of the store and have a cafe at the back, you might list your scope in one of the following two ways:

  • Sell clothing and operate a cafe and engage in any other lawfully permitted business activities.
  • Engage in lawfully permitted business activities.

The shorter and broader type statement (the second one) would be more commonly used.

But like I said, in China how you would list your business scope is very different. Let’s take the clothing store with a cafe in the back. You might list the scope for that as follows:

  • Operate a retail business.
  • Operate a retail clothing business with a cafe.

But get this. Depending on the Chinese city (or even the district within that city) in which you are seeking to form your clothing-cafe WFOE, there is a very good chance your WFOE application will be denied for being too broad. When listing business scope for a China WFOE registration, you usually must describe the scope precisely and in a fair amount of detail. After you do that, Ministry of Commerce (MOFCOM) and the Administration of Industry and Commerce (AIC) will almost certainly review every word of your proposed scope to determine if what you are proposing your WFOE will do in China is even allowed to be done by a WFOE (as opposed to by a Chinese domestic company or by no private entity at all.

The Chinese Commerce authorities will also review your WFOE’s business scope to determine whether it can all be done within one WFOE or whether two or more WFOEs will be required. Take the clothing-cafe business. It’s impossible to know what every district in every city in China would do with that sort of scope, but I would say the odds are good that you will need to form two WFOEs to both sell clothes and coffee and baked goods.

It is important you get your business scope right the first time. If you get it wrong, in most places of China, this will mean you will need to negotiate a new scope with the Chinese authorities. But in some places, you are at risk of your WFOE being denied and your having to start all over on your WFOE formation. I repeat: it is important you get your business scope right the first time.

Choosing the correct scope of your China WFOE is also critical for avoiding problems months and even years after your WFOE has been formed. Although it’s not common for Chinese authorities to censure an organization for periodically stepping outside the bounds of its officially authorized business activities to engage in auxiliary activities, the ability to issue tax invoices to its partners for the specific services rendered is very important. These clients or customers will normally insist upon a specific invoice based on a certain value-added tax (VAT) rate for use as a tax offset or deduction, and it would not be unusual for them to refuse to make payment for services rendered if the appropriate invoice cannot be issued. Therefore, because a VAT invoice cannot be issued at the relevant tax rate for activities not specified in the business scope, it is critically important to negotiate approval of a sufficiently broad and relevant business scope with careful consideration from the beginning of one’s anticipated scope of business activities and client’s and customer’s required invoicing.

 

I then explain the various options foreign companies have for going into China — still essentially confined to going it alone as a Wholly Foreign Owned Entity (WFOE, a/k/a Wholly Owned Foreign Entity or Enterprise or WOFE), Representative Office (Rep Office) or partnering with a Chinese company in the form of a Joint Venture (JV).

Then we start talking about what sort of entity makes sense for this particular company. Nine out of ten times, the company wants to go into China on its own as a WFOE and that is where the problem sometimes starts. The company has heard that China is very capitalistic and “wide open” and did not know that is not really the case, particularly as it relates to foreign companies.

China has what it calls its “Catalog for the Guidance of Foreign Invested Enterprises.” This catalog divides foreign investment into “encouraged,” “restricted” and “prohibited” investments. Foreign companies cannot invest in prohibited industries and foreign investment in restricted industries typically requires the foreign company joint venture with a Chinese company. Industries that are not classified into any of the three categories are generally assumed to be permitted.

So every once in a while, I have to inform the American or European company that it simply cannot go into China at all or that it can only do so if and when it has found a Chinese company with which it can joint venture. The moral of the story is that it makes sense to find out whether your proposed company can work in China at all, and to do so before funding market and operations research or China trips.

But this research is oftentimes not so simple and that is because a lot depends on how the business is defined when the application is made. The business scope is relevant to the catalog on foreign investment because a business sometimes can fit within one or more categories of the catalog and how you describe your business scope on your WFOE application can make the difference between approval and rejection. You sometimes can massage the description of your business scope to obtain more favorable classification.

BUT — and this is why I am writing this post now — if you under or overreach on the description of your business scope, you might find yourselves in big trouble.  We are getting an increasing number of calls from American companies in trouble with the Chinese government for doing things in their business that were not mentioned in the business scope section of their initial WFOE.

In some cases, the companies have admitted to us that they were never “really comfortable” with the business scope mentioned in their applications, but that the company they had used to form their WFOE had “pushed” them into it as it would “make things much easier.” In some cases, the scope of the business changed after the application was submitted and the company had failed to secure approval in advance for the change. And in some cases, the company probably would never have been approved at all had it been upfront and honest in its application. In nearly all instances, the companies had managed to secure local approval but were now in trouble with Beijing, which constantly is auditing these applications. In one instance, the local government went back and changed its mind, probably after conducting an audit of its own.

I cannot go into any more detail on these matters, but I can give this advice: applying for a WFOE in China involves a heck of a lot more than just filling out a form and getting approval. It does matter for what you get approved and you (or whomever you are using for your WFOE application) need to know China’s foreign investment catalog inside and out before applying. You then must tailor your application to meet both the requirements of the foreign investment catalog AND the reality of what you will be doing in China. A failure to comply on both fronts will lead to, at best, a rejection of your application and, at worst, being shut down months or years later.

If you take away nothing from this post, please at least understand that your getting local government approval for your WFOE does not mean you are out of the woods. There is little to no benefit in getting approval for a non-conforming WFOE.
Corporate Business Scope

 

Funding and Registered Capital

Although China has moved to eliminate the requirement of a minimum capital injection (aka, “Registered Capital”) as a condition for incorporating a WFOE, the reality remains that each application for incorporation will be reviewed on a case-by-case basis and Chinese authorities at MOFCOM will typically require a minimum commitment of between RMB 200k to RMB 500k for a basic consulting WFOE (A manufacturing WFOE would normally be required to inject considerably more Registered Capital). They will review a “feasibility study report” submitted as part of the incorporation application (a projection of expected expenses and profits for the first three years of the WFOE’s life) and use it as a rough guide to set the minimum Registered Capital. Once injected, the Registered Capital monies will remain available to fund the activities of the WFOE until it achieves self-sustainability – or the Registered Capital would need to be increased.

There is no such thing in China as a shell holding company. All WFOEs are expected to achieve sustainability, and, if they do not, then they may be subject to undesirable scrutiny by Chinese tax and regulatory officials.

For these reasons, it is important to plan the funding and sustainability of the WFOE from the moment of incorporation until profitability and to set its Registered Capital accordingly. Investors need to strike a balance between infusing the WFOE with sufficient capital to fund its initial growth but not with so much that the capital sits idle and does not earn a return, trapped in the foreign currency account of the WFOE. Investors from foreign jurisdictions might speculate the funds could merely be returned to the foreign shareholders if not needed, but reversing and returning Registered Capital from China should be regarded as effectively impossible from a practical point of view. Therefore, investors should thoughtfully consider how much Registered Capital would be needed to achieve sustainability.

For those investors that do not anticipate achieving profitability and expect on-going operational costs for those investors whose WFOE unexpectedly fails to achieve its objectives, recourses may be given to alternative funding mechanisms. Of course, one option is to increase the official Registered Capital of the WFOE and inject additional capital. This is a tax-free transaction, and therefore highly efficient from a tax point of view. However, the challenge presented is that such a method would require that the business license be amended to reflect the increased Registered Capital, then the monies injected. This is a time-consuming and slow process, as it would require investors to resubmit their business plan and “feasibility study” to MOFCOM for approval. The business license itself would need to be reissued and a number of formal governmental registrations updated, and the WFOE may have consumed all remaining cash.

Related Link IconRELATED: Changing the Registered Capital of a Company in China

Consequently, another funding mechanism often resorted to is a related-party transaction between the parent shareholder and WFOE, whereby “consulting services” are provided to the parent under the terms of the consulting agreement in return for payments that fund the WFOE’s operations. Because this is a “current account” transaction, it can be completed rapidly despite China’s foreign exchange and capital account restrictions. The downside is that it is a taxable transaction subject to VAT of at least six percent – the VAT rate for “modern services” such as consulting – and will also be subject to corporation income tax. The transactional fees and VAT and corporate income tax would need to be anticipated and budgeted were a WFOE to be funded with this alternative funding mechanism. Despite the “dodgy” sounding nature of the transaction, it is a common means for WFOEs to receive funding if investors do not wish to repeatedly increase the Registered Capital. Many such WFOEs were originally intended to be cost centers that would not generate adequate revenue, if any, to be self-sustainable.

Since China effectively disallows the establishment of foreign not-for-profit organizations, many of those that choose to conduct operations in China establish themselves as WFOEs (for-profit enterprises) and often resort to such a funding mechanism to maintain sufficient cash flow for operations.

– See more at: http://www.china-briefing.com/news/2016/01/15/strategic-considerations-when-establishing-a-wfoe-in-china-part-1-business-scope-and-registered-capital.html#sthash.Y8PgnRRX.dpuf